Shareholders Agreement-Its Basis and A Paradigm Shift In Its Status

In India, the Companies Act defines two types of companies, which are, public and private. There are Memorandum of Understanding and Articles of Association to bind the shareholders and the company which is required by law to be formed.  The Articles of the Association is a contract between the company and its members and it defines various aspects such as the proceedings to be taken by the board, the rights of the directors, the mode of raising capital and its shares etc. Apart from these two documents, the shareholders also enter into another agreement known as the shareholder’s agreement (SHA). This agreement is not required to be compulsorily designed as per the Companies Act but due to the complexity of the transaction and procedures carried out in the companies these days the shareholders of the large and medium size companies makes these agreements defining their rights and obligations to each other.

In this article, we will discuss about the jurisprudential basis of the shareholders’ agreement and the paradigm shift in the judicial approach regarding the existence and the overriding effect of SHA vis-à-vis the Articles of Association.

Jurisprudential Basis

Previously, the private companies were formed by taking the capital from friends and relatives and among the known members of the society. So, the trust quotient in the money transactions involved was higher as all the shareholders know each other and also there was a sense of trust and understanding among them. With the passage of time and due to more and more avenues to raise money, the companies expanded in their activities and their requirement of capital also arose. Also, the various investors which are not related to the members of the started investing their money into the company based on its performance in the market instead of the relation they shared between each other. Now, due to the same a situation arose wherein the members do not know each other and so they did not share the same trust and understanding as earlier. This led to the need of the shareholders agreement between the members.

Also, one more important reason of the need to formulate a shareholder agreement was due to the fact that there are two set of shareholders in any company, which are, majority and minority shareholders. Now, the majority shareholders are those which hold more that 51% shareholding in the company and the minority shareholders are those which hold less that the above said percentage. Every decision of the company is taken on the basis his share in the total capital of the company. So, while making any important decision the majority shareholders will have an upper hand as compared to the minority shareholders and the decision will be ultimately be taken as per the majority holders though the decision could have a negative impact on the situation of the minority shareholders. Also, in another scenario wherein for example the company is not earning the estimated profits and the majority shareholders want to sell the company to a third party and the buyer in that wants to take full control of the company, then in that case the approval of even the minority shareholders is also required. Now, if the minority shareholders are not satisfied with such proposal of selling the company and if their rights as shareholders are affected due to such proposal, they can oppose against the same and the whole proposal of sale of the company which may be the need of the hour keeping in mind the present situation of the company important cannot be executed. Herein, the majority shareholders are affected due to the minority shareholders. So, herein also the need for a strong and thorough SHA would help in helping the company out of this complex situation.

Paradigm shift in Judicial Approach

The shareholders agreement have been an area of discussion for many decades as the main issue is that the Companies Act do not have any mandate to make such an agreement but at the same time all the obligation mentioned under the agreement are covered as they are covered in a contract. Also, there is a change in the view of the judiciary regarding its standing vis-à-vis the Articles of Association.

The first case that was raised the issue regarding the SHA was V.B. Rangaraj v. V.B. Gopalkrishnan[1] in which there was SHA which had some restriction regarding the transfer of shares. The main issue herein in the Supreme Court was that whether such agreement can contain the clause regarding restriction on transfer of shares if such a clause is in contradiction with the contents of the Articles of Association (AOA) of the company which was a private company. The Court observe that a private company as per the Companies Act means any company which have a restriction of the right of transfer of shares as per the contents of the Articles of Association which is an agreement between the company and the shareholders and also as per Section 82 of the Companies Act, 1956 the share or the interests of the member are termed as movable property which can be transferred only in the manner provided in the AOA of the company. Therefore, the court ruled that any agreement of a private company such as the present SHA which restricts the transfer of shares in which the company itself is not a party or which is not laid down in the AOA of the company is not valid.

The second important case in this respect was M.S. Madhusoodhanan v. Kerala Kaumudi (P) Ltd[2] in which the issue was regarding the clause contained in the SHA for the transfer of shares of two members to Mudhusoodhanan in a certain percentage at the time of their death. The parties cited the V. Rangaraj case but the court ruled out this contention saying that in V. Rangaraj case the issue was regarding the transfer of new share in which the company has an active role in issuing the shares but in the present case the issue is regarding the transfer of share amongst the shareholders where the company does not have any active role so when there is any clause in the SHA regarding the transferability of share amongst the shareholders themselves then the company itself is not required to be a party in such agreements.

Diversion From Old View

So, we can see from the above judgements that earlier the courts use to follow a common rule regarding the SHA, i.e., if they are inconsistent with the Articles of Association then they are not enforceable but in the few judgements by various High Courts we can see a diversion of the above rule.

In Spectrum Technologies USA Inc. v.  Spectrum Power Generation Co Ltd.[3]  which is a Delhi High Court judgement in which there was a agreement between the promoters in which the Spectrum Power Generation Company was asked to be bound by the terms of the agreement and shall amend its MoU and AoA according to the terms of the agreement. SPGL gave the contention that it is not bound to amend the MoA and AoA as it was not party to the promoters agreement and cited V. Rangaraj case but the court held that V. Rangaraj case have no applicability in the present case because in that case company had not agreed in the agreement to amend the contents of AoA and bring them in confirmation with the Promoters Agreement which had been done in the present case. So in above case though the same had not been incorporated in the AoA then also the contents of the SHA were termed as enforceable.[4]

In the Delhi High Court judgement of Modi Rubber Co. v. Guardian International Corp[5]., there was SHA wherein there was a prohibition on the parties from undertaking any other business which is related to the business of the float glass but the same had no mention in the contents of the AoA and so the party contended that they are not liable to oblige for the same. The court said that the SHA in question is not unenforceable as it is not in contravention to AoA and the Companies Act and therefore held that the SHA is enforceable even the same is not mentioned in the AoA of the company.

Reiteration of Old View

But the recent judgement of High Court of Delhi reiterated the view taken by the Supreme Court in V. Rangaraj case in the case of Worldphone India Pvt. Ltd. & Ors. v.WPI Group Inc., USA[6] in which the board of directors had passed resolution in which they approved rights issue as per the Articles of Association of the company irrespective of the fact that such a decision required the approval of the petitioner as per the SHA. The court in this case held that when the AoA of the company does not contain any provision in relation to the requirement of such vote then such a clause mentioned in the SHA would not be enforceable without inserting such provision in AoA first.

Conclusion

So, we can see that though the High Court with the passage of time have taken a liberal view regarding the insertion of terms in SHA without inserting the same in the AoA of the company but some courts even in the recent time had reiterated the previous view of the Supreme Court. Moreover, whatever diverging views have been taken by the different high courts, at the end the Supreme Court had not changed its view which is to incorporate the changes brought out by the SHA in the AoA first and then only they will be enforceable.

REFERENCES-

[1] AIR 1992 SC 453

[2] (2004) 9 SCC 204

[3] 2000 (56) DRJ 405

[4] ibid

[5] 2007 (2) ARBLR 133 (Delhi)

[6] (2013)  178 CompCas 173 (Del)

[7] IBA Guide on Shareholder’s Agreement, https://www.ibanet.org/LPD/Corporate_Law_Section/Clsly_Held_Growing_Busi_Entprs/shareholderagreements.aspx

[8] http://www.aralaw.com/files/Enforceability%20of%20Shareholders%20Agreements.pdf

[9] Tigadi, Rohan, Enforceability of Shareholder Agreements in India (March 28, 2014). Available at SSRN: https://ssrn.com/abstract=2417246 or http://dx.doi.org/10.2139/ssrn.2417246

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